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Presentation on theme: "MBMC The Economics of Information The Economics of Information."— Presentation transcript:

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 2 Introduction The invisible hand theory assumes that buyers are fully informed. Given that consumers are not fully informed, they must employ strategies for gathering information.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 3 How the Middleman Adds Value Example How should a consumer decide which pair of skis to buy?  Skis R Us has a....... oknowledgeable sales staff oand a large inventory  They Recommend Salomon X-Scream 9 skis for $600

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 4 How the Middleman Adds Value Example How should a consumer decide which pair of skis to buy?  The skis can be purchased on the Internet for $400 Question Is spending $600 on the right skis better than $400 on the wrong ones?

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 5 How the Middleman Adds Value How does better information affect economic surplus? Ellis wants to sell a Babe Ruth baseball card.  His reservation price is $300.  An ad in the local newspaper cost $5.  eBay cost is 5% of the Internet auction price.  The maximum price in the local market is $400.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 7 How the Middleman Adds Value Example How does better information affect economic surplus?  Economic surplus is increased when a product goes to the person who values it the most.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 9 The Free Rider Problem An incentive problem in which too little of a good or service is produced because nonpayers cannot be excluded from using it The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 10 Economic Naturalist Why is finding a knowledgeable salesclerk often difficult? Why did Rivergate Books, the last bookstore in Lambertville, NJ, recently go out of business? The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 11 Two Guidelines for Rational Search Additional search time is more likely to be worthwhile for expensive items than cheap ones Prices paid will be higher when the cost of a search is higher The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 12 Example Should a person living in Paris, Tx, spend more or less time searching for an apartment than someone living in Paris, France? The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 13 Example Tom and Tim are shopping for a used upright piano. Tom has a car & Tim does not. Which one should expect to examine fewer pianos before making a purchase? The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 14 The Gamble Inherent in Search When engaging in further search there are additional costs and uncertain benefits and, therefore, there is a degree of risk or gamble from the search. The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 15 Determining whether or not to take the gamble: Compute the expected value of the gamble  The sum of the possible outcomes multiplied by their respective probabilities The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 18 Determining whether or not to take the gamble: Risk-neutral person  Will accept any gamble that is fair or better Risk-averse person  Will refuse any fair gamble The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 19 Example Should you search further for an apartment?  Searching for an apartment in a neighborhood where identical apartments rent for $400 & $360  Of the vacant apartments, 80% rent for $400 and 20% rent for $360  You must visit the apartment to get the rental rate The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 20 Example Should you search further for an apartment?  The first visit is a $400 apartment.  The opportunity cost of an additional visit is $6. The expected value of another visit:  (.2)($34) + (.80)(-$6) = $2 The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 21 The Commitment Problems When Search is Costly What happens when, by chance, a more attractive option comes along after the search has ceased? The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 22 The Commitment Problems When Search is Costly When information is costly and the search must be limited, a relationship may dissolve. The Optimal Amount of Information

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 24 Asymmetric Information Situations in which buyers and sellers are not equally well informed about the characteristics of goods and services for sale in the marketplace.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 31 Asymmetric Information The Lemons Model People who have below average (lemons) cars, are more likely to want to sell them. Buyers know that below average cars are likely to be on the market and lower their reservation prices.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 32 Asymmetric Information The Lemons Model Because used car prices are low, people with good cars keep them longer. The average quality of used cars falls even further.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 33 Asymmetric Information Example Should you buy your aunt’s car?  4-year old Accord  The asking price of $10,000 is the blue book value.  You believe the car is in good condition.  It is a good deal because the blue book value is the equilibrium price for below average cars.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 34 Asymmetric Information Example How much will a naïve buyer pay for a used car?

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 35 Asymmetric Information Assume There are only good cars and lemons. 10% of all new cars are lemons. Good used cars are worth $10,000 and lemons are worth $6,000. The used car market is 90% good cars and 10% lemons.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 37 Asymmetric Information Example Who will sell a used car for what the naïve buyer is willing to pay?  Would not sell a good car that is worth $10,000  Would sell a lemon that is worth $6,000  Only lemons will be on the market  Price will fall to $6,000

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 38 Asymmetric Information What Do You Think? If you have a good used car for sale, how can you get a higher price?

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 39 Asymmetric Information The Credibility Problem In Trading People tend to interpret ambiguous information in ways that promote their own interests.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 40 Asymmetric Information The Costly-to-Fake Principle To communicate information credibly, a signal must be costly or difficult to fake.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 41 Asymmetric Information Economic Naturalist Why do firms insert the phrase “As advertised on TV” when they advertise their products in magazines and newspapers? Why do many companies care so much about elite educational credentials?

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 43 Asymmetric Information Statistical Discrimination The practice of making judgments about the quality of people, goods, or services based on the characteristics of the groups to which they belong.

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 44 Asymmetric Information Economic Naturalist Why do males under 25 years of age pay more than other drivers for auto insurance?

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 45 Asymmetric Information Adverse Selection The pattern in which insurance tends to be purchased disproportionately by those who are most costly for companies to insure

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MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 47 Asymmetric Information Moral Hazard The tendency of people to expend less effort protecting those goods that are insured against theft or damage